Activity-Based Costing

Traditionally, overhead costs are assigned based arbitrarily on the rate of either direct labor or direct materials associated with production. This makes sense when companies only make a few products, production processes are simple, and overhead costs are less pervasive. However, today production processes are more complex, companies make a wider array of products, and fewer costs are directly traceable to units of production. To address this, companies use activity-based costing (ABC).

Specifically, activity-based costing identifies and traces costs and expenses to activities and then to specific products. ABC uses multiple factory overhead rates based on activities. Activities are the types of work, or actions, involved in a manufacturing process or service activity. For example, assembly, inspection, and engineering design are activities.

The estimated activity costs are allocated to products using an activity rate. Activity rates are determined as follows: Activity Rate = Estimated Activity Cost / Estimated Activity Base Usage

Illustrated Example of Activity-Based Costing

Comparing Two Products under Traditional and Activity-Based Costing

Compare two projects under development by the same company. The following are a few aspects of each products development process relevant to costs.

Product S		Product T
Requires 3,680 hours of testing		Requires 920 hours of testing
Requires 4,200 units of computing power		Requires 1,800 units of computing power
Requires 30 developer hours to implement		Requires 70 developer hours to implement

Cost Items	Cost of Each Activity
Testing:	$27,600
Computing power:	$41,400
Developer hourly cost:	$15 per hour

Traditional Costing

Traditional costing would take the proportion of a direct cost, such as direct labor hours, and use it as the basis for allocating overhead costs, such as computing power and testing. In the following table, use developer hours as the basis for assigning overhead costs (computing and developer costs) to each project. If required, round your answers to the nearest dollar.

Product S			Product T
Percentage of developer hours	30%		Percentage of developer hours	70%
Testing cost	8,280		Testing cost	19,320
Computing cost	12,420		Computing cost	28,980
Developer cost	450		Developer cost	1,050
Total cost	21,150		Total cost	49,350

Percentage of developer hours

+ Percentage of developer hours for Product S (30%)

Allocation basis for Product S: The number of labor hours associated directly with Product S, as a percentage of all developer hours worked (regardless of product). The amounts for overhead to be allocated are multiplied by this value to determine the overhead to be assigned to Product S under the traditional costing method.

30

(30+70)

+ Percentage of developer hours for Product T (70%)

Allocation basis for Product T: The amount of labor hours associated directly with Product T, as a percentage of all developer hours worked (regardless of product). The amounts for overhead to be allocated are multiplied by this value to determine the overhead to be assigned to Product T under the traditional costing method.

70

(30+70)

Review the resources each product (S and T) requires for production and compare that to the costs calculated above under traditional costing. Does traditional costing serve as an accurate gauge of costs? No

Feedback

Using traditional cost assignment means pegging overhead costs based on a direct cost, such as direct labor or direct materials. In this case, you use direct labor (developer hours) as the basis for overhead allocation.

For product S, the percentage of developer labor costs as a proportion of the whole is already calculated. This is the figure that, when multiplied by the overhead values, will yield the overhead assigned to each project under traditional costing.

Activity-Based Costing

Using the data above for products S and T, calculate the costs using activity-based costing. Allocate the costs of testing, computing, and development based on the rates of activity consumed by each product's development process. If required in your computations, round per unit costs to the nearest cent. Round your final answers to the nearest dollar.

Cost	Activity Base
Testing	Hours of testing
Computing cost	Units of computing power
Developer cost	Development hours

Product S			Product T
Testing cost			Testing cost
Computing cost			Computing cost
Developer cost			Developer cost
Total cost			Total cost

Feedback

The budgeted activity costs are assigned to products using factory overhead rates for each activity. These rates are called activity rates because they are related to activities. Activity rates are determined as follows: Activity Rate = Budgeted Activity Cost / Total Activity Base Usage

The costs are allocated to the product by multiplying the activity-base usage by the computed activity rate.

Activity-based costing for varying batch production

A manufacturing company has the following two activities associated with completion of products:

1. The setting up of machines for running batches of products
2. The actual production of units produced

The company has annual manufacturing overhead costs of $2,000,000, of which $200,000 is directly involved in setting up machines for batch runs. During the year, the company expects to perform 400 machine setups, one setup per batch for a total of 400 batches of production. Assume that the batch sizes vary considerably, but the work involved in setting up the machines is not appreciably different from one job to the next.

If the company estimates that the $200,000 costs associated with setups will yield 400 setups this year, the cost associated directly with each setup will be $XXXX per setup. Because each job will require its own setup, setup costs are viewed as batch costs. Because $200,000 of the $2,000,000 are costs associated with setups, this means that costs associated directly with the production of units equal $XXXX.